Lectures on Macroeconomics, No. 15

This lecture is on the household's "make or buy" decision. The more we outsource production, the more economic activity there is. In a recession, we cut back on outsourcing.

In business, there is something called the "make or buy" decision. Should an automobile manufacturer make tires, or should it buy them? Should the headquarters manage its own cafeteria, or should it hire a food service company?

For households, there is a similar "make or buy" decision. Should we eat at home, or should we eat out? If we eat at home, should we heat up a frozen pizza, or should we make a pizza from scratch? Should the basil on our pizza come from the market, or should we grow basil in our garden?

When it comes to reported GDP, the more we outsource the more gets counted as economic activity. The labor effort that we put into cooking or gardening does not get counted. In addition, if we choose to take income in the form of leisure, that does not count as GDP.

The national income accounts are not terribly misguided in only counting outsourced activity as GDP. For most goods and services, the value of what we can produce if we make them ourselves is essentially zero. My ability to perform surgery on myself is essentially zero. My ability to manufacture a refrigerator is essentially zero. My ability to raise and milk a cow is essentially zero. I have the ability to provide intellectual services--teaching, writing, financial calculations, computer programs, and so on. The value of what I produce when providing those services is so much higher than the value of what I produce when I engage in agriculture, crafts, or mechanical manufacture that you might as well value the work I do in those latter activities at zero.

What the national income accounts are saying is that the more we buy and the less we make, the higher the level of GDP. There is some logic in this. When we buy, we take advantage of labor specialization and roundabout production.

Labor specialization is what Adam Smith marveled at. In fact, specialization within a pin factory is relatively uninteresting compared with specialization between factories. Having separate factories for pins and shirts probably generates even more gains from specialization than separating the functions within each factory.

People invent new businesses that create new forms of specialization. Fifty years ago, who knew that we needed meeting planners, financial advisers, or lawn care services?

Some of the biggest increases in specialization are within the business sector itself. Just to take one example, thirty years ago any company that tracked data wrote its own database software. Now, everybody uses off-the-shelf software, such as Oracle.

The value proposition of a new service, whether for businesses or consumers, is this: don't do X, because we can do it for you more cost-effectively. Increasing specialization adds value.

Roundabout production is the way Austrians describe the substitution of capital for labor. Instead of using only labor to perform agricultural tasks, we use farm machinery to augment labor. This process is roundabout, because labor first has to be used to make the farm machinery. You can think of the farm output as being produced by current labor working with machines that were built using prior labor. You can think of the farm output as coming from a combination of current labor and prior labor.

Both specialized production and roundabout production carry risks. If you specialize in driving a horse and buggy, and then the automobile is invented, the value of your work goes way down. If you build farm machinery that turns out not to be needed, the value of your product goes way down.

Given all of the risks and potential imbalances in specialized and roundabout production, it is remarkable that the economy works as well as it does. That is, it is amazing that most people can remain in their current jobs for months on end and that most people can remain in their current occupations and career path for many years. It is amazing that millions of new people enter the labor force every year, bringing different skills than the people leaving the labor force, and the economy ordinarily is ready for them.

Of course, now we are seeing the process not work so well. We are seeing less outsourcing by households and businesses. Intuitively, it is easy to understand why.

Suppose that a household were told that it was going to suffer an economic setback. It might be a loss of wealth in the stock market or a spell of unemployment for someone in the labor force. That household might decide to obtain fewer goods and services in the market. The family might decide to do more cooking and less dining out. It might decide to suffer the disutility of living in a smaller house rather than buying a bigger house. It might decide to live with an older car rather than buy a new car.

One way to think of a recession is that it consists of large numbers of households shifting decisions from "buy" to "make." In a real business cycle model, these are rational responses to shifts in relative prices, perhaps due to tax changes. But that is not the thrust of this lecture.

At the moment, we are hearing of automobile dealerships that are going to be closed. Presumably, this means that sales staff and other personnel are going to be out of a job. I do not think it is useful to describe this as intertemporal substitution on their part.

The problem for the unemployed auto salesmen is that they have to adjust their wage rate (down), their skill set (to apply to something other than auto sales), or both. Until that happens, their households probably will be doing less buying and more making. This in turn will adversely affect the incomes of other households, who otherwise could be producing goods and services that the auto salesmens' households would be buying.

When an economy has a high degree of specialization and roundabout production, it is possible to get badly out of balance and to take a long time to recover. In 1830, a laid-off urban worker could switch to agricultural labor at relatively little loss of income. Not so today.

The challenge for an economy in a recession is to develop new patterns of specialization and roundabout production. This process takes time.

How do conventional Keynesian stabilization policies work in this model? That is a question for later discussion.

IIUC, Europeans do more household production because of the tax rates. Given their higher marginal tax rates on both consumption and production, their lengthy vacations cost them less income and provide more time for household production. The French are also forced into more household production with their maximum work week regulations.

I wonder if Bryan should consider how even Europeans with jobs are "unemployed" on vacation for longer than Americans.

Make or buy is also an important consideration in tax analysis. When labor is highly taxed, it's a lot cheaper to do-it-yourself than to hire someone to do it. Of course, if you are like me, you probably don't do it as well as a specialist, but that's part of the deadweight loss.

Do it yourself was a big deal in Sweden in the 1980s when marginal tax rates were 80%. When the tax rates went down, market transactions went up.

Very interesting series, this is a good account for the layman so I would suggest that if you're going to make a statement such as "I do not think it is useful to describe this as intertemporal substitution on their part," you should provide a brief explanation. I assume this is a response to the assumption of real business cycle models?

The national income accounts are not terribly misguided in only counting outsourced activity as GDP. For most goods and services, the value of what we can produce if we make them ourselves is essentially zero. My ability to perform surgery on myself is essentially zero. My ability to manufacture a refrigerator is essentially zero. My ability to raise and milk a cow is essentially zero.

Maybe I'm missing your point about GDP, but because your ability to perform surgery/make a fridge/milk a cow is valued at zero, you don't do it. The it-not-actually-happening is a good enough reason not to count it towards GDP, and would be good enough even if you had some ability to milk a cow, and just didn't.

I can't make a fridge, but it turns out I can fix a washing machine and a clothes dryer. Since I'm unemployed right now, the eight hours those tasks took was worth more to me than $400 in service calls would have been, so I did it. (Eight hours of time was also a lot less than my share of hand-washing dishes would have been; I won't try to tally the costs of another couple months of my wife putting wet laundry outside in what I swear Nature kept misinterpreting as some sort of rain dance.)

It's actually a problem that GDP doesn't somehow account for that (beyond the $12 and $13 in shipping I paid for the $25 dryer part). Certainly the appliance repair shop is booking $425 less in revenue than it would have. And I have $400 more than I would have.

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